IPO Basics: Getting In On An IPO

When a company decides to raise money via an IPO it is only after careful consideration and analysis that this particular exit strategy will maximize the returns of early investors and raise the most capital for the business. Therefore, when the IPO decisions is reached, the prospects for future growth are likely to be high, and many public investors will line up to get their hands on some shares for the first time. Those who receive an IPO directly are able to purchase at the IPO price, which may be quite a bit below the market price when it eventually starts trading on an exchange. When more people demand shares of an IPO than the number of shares being offered, it is said to be oversubscribed. Getting a piece of a hot IPO that is oversubscribed is very difficult, if not impossible. To understand why, we need to look at how an IPO comes to be, a process known as underwriting.

When a company wants to go public, the first thing it does is hire an investment bank. A company cannot simply sell its shares on its own in an unregulated manner, and this is where Wall Street comes in. Underwriting is the general process of preparing for and raising money via either debt or equity. You can think of underwriters as brokers who stand between companies and the investing public, and who market and sell those initial shares. The biggest underwriters in 2016 were Goldman Sachs Group Inc. (GS), Credit Suisse Group (CS), Merrill Lynch (BAC) and Morgan Stanley (MS).

The company looking to go public will first need to meet some milestones before they can approach an investment bank. In particular: the company must develop an impressive management and professional team who will be able to steer the company once it’s public, grow the company's business with an eye to the public marketplace, obtain audited financial statements using IPO-accepted accounting principles, establish anti-takeover defenses such as poison pills, develop good corporate governance including an independent board of directors and qualified officers, and time the IPO decision to take advantage of favorable IPO windows while avoiding going public during an economic downturn.

Once these criteria have been met, the company will meet with potential investment banks to discuss the amount of money a company will raise, the type of securities to be issued, and all the other details in the underwriting agreement. The deal can be structured in a variety of ways. For example, in a firm commitment, the underwriter guarantees that a certain amount of money will be raised by buying the entire offer itself and then reselling shares to the public. In a best efforts agreement, however, the underwriter sells securities for the company but does not guarantee the amount raised. Investment banks are often hesitant to shoulder all the risk of an offering, so the lead investment bank can form a syndicate of underwriters by soliciting other banks who each sell a part of the issue.

After all sides agree to a deal, the lead investment bank puts together a registration statement to be filed with the SEC. This document contains information about the offering as well as company data such as financial statements, management background, any legal problems, where the money is to be used and insider holdings – and also the proposed ticker symbol that the company will trade under once it’s been listed on a stock exchange. The SEC then requires a cooling off period, in which they carry out due diligence and make sure all material information has been disclosed. Once the SEC approves the offering, a date (the “effective date”) is set when the stock will be offered to the public.

During the cooling off period the underwriter puts together what is known as the red herring document. This is an initial prospectus containing all the information about the company except for the offer price and the effective date, which aren't yet known at that time. With the red herring in hand, the underwriters and the company market the company’s shares to public investors – building hype and interest for the issue. Underwriters often go on a road show, also known as the dog and pony show, where big institutional investors are courted and early demand for the shares is evaluated.

As the effective date approaches, the underwriter and company sit down and decide on the offering price – the price at which the company will sell its shares. This is the price at which the company will raise capital for itself, since after that initial sale, its stock will trade on the secondary market and the proceeds of share sales will go directly to whoever owned those shares and not to the company. The offering price depends on the company’s ambitions, the success of the road show and, most importantly, current market conditions.

As you can see, the road to an IPO is a long and complicated one. You may have noticed that individual investors aren't involved until the very end. This is because small investors aren't the target market of the underwriters. Small investors simply don't have the amount of money needed by the company and therefore hold little interest for the syndicate. If underwriters think an IPO will be successful, they'll usually pad the pockets of their favorite institutional client with shares at the IPO price. The only way for an individual investor typically to get shares (known as an IPO allocation) is to have an account with one of the investment banks that is part of the underwriting syndicate, or with a broker who has itself received an allocation and wishes to share it with their clients. But don't expect to open an account with $1,000 and be showered with an allocation. You often need to be a frequently trading client with a large account to get in on a hot IPO. There are exceptions to every rule and it would be incorrect for us to say that it's impossible for individual investors to get access to an oversubscribed IPO. Just keep in mind that the probability isn't high.